Strategies for maximizing tax-advantaged outcomes
November 22, 2022
November 22, 2022
When markets are volatile, it's helpful to refocus your clients on things they can control. How money is invested, and when and how income is generated are both areas you can control for your clients. Wise decision-making in these areas may reduce their tax bill.
Using a tax-deferred retirement account is a good idea. Using two or three may be better. An up-front tax deferral through contributions to a traditional IRA or employer-sponsored retirement plan might be most beneficial in some years, but contributions to a Roth IRA may be even more beneficial as growth to a Roth IRA is tax-free. Roth IRA contributions are made after-tax, so there's no deduction. Other tax-advantaged accounts include HSAs, 529 plans, and annuities.
Roth IRAs offer tax-free investment growth and income, but contribution limits may apply to high earners. High earners cannot take advantage of Roth accounts directly unless they have a Roth 401(k) through their employer. However, conversions may provide an option around the Roth IRA income cap. High earners can consider nondeductible contributions to a traditional IRA and may retain the ability to convert those funds to a Roth later.
If clients have a high-deductible health plan (HDHP), consider an HSA. HSAs provide unique tax benefits: Contributions are tax-deductible, investment growth is tax-deferred, and no taxes or penalties apply if the funds are used on doctor's visits, medications, or other qualified medical expenses. Other accounts don't offer this three-pronged tax break but it's also important to make sure clients know their contribution limits and the trade-offs of a high-deductible health plan. Additionally, spouse and non-spouse beneficiaries receive much different tax treatment when inheriting an HSA. Spouses can treat inherited HSAs as their own; for non-spouses, the account becomes immediately taxable at death.
Tapping into retirement savings may not be ideal. But it's good to know that with various tax-advantaged accounts, there's potential flexibility for early withdrawals. For example, clients can withdraw Roth IRA funds without tax consequences up to the contribution amount.
While 401(k) plans often offer the option to take a loan or hardship withdrawal, traditional IRA accounts have exceptions for penalty-free withdrawals as well, such as home buying ($10,000 lifetime limit) or qualified education expenses.
While there's no single order of priority for these accounts that works for everyone, a client's individual circumstances can help guide you. Here are some general guidelines to consider:
Advising clients on which tax-deferred and tax-free accounts to use, and when, is an important way that advisors can create value for their clients. Equally important is knowing how to allocate your client's money across these account types to meet both short-term and long-term financial goals.
A diverse asset-allocation plan is essential for smart investing, but certain asset classes are better suited to tax-deferred accounts and others to taxable accounts. Portfolio construction should consider the tax ramifications of various asset classes with the tax treatment of account types. The primary drivers of asset location decisions should include: applicable tax rates, whether the holding is actively or passively managed, any wealth-transfer indications, and the implementation of ongoing rebalancing strategies.
Guidelines for which assets to place in tax-deferred accounts:
While these are solid guidelines, it's important to consider all aspects of an individual's financial plan in personalizing their asset-location strategy. For example, an individual with a specific wealth-transfer bequest may benefit from holding those shares outside of a tax-deferred account to receive a step up in basis.
Drawing down accounts in retirement should be an orderly process. In generating income, first rely on distributions that cannot be avoided like required minimum distributions (RMDs) from traditional 401(k) or IRA accounts. Additionally, annual dividends and capital gain distributions from active holdings in taxable accounts cannot be avoided and are a solid second source of income. Additional withdrawals from taxable accounts and non-RMD withdrawals from tax-advantaged accounts should generally come last since these are the most burdensome for taxation. For additional income, it is best to consider the client's current and future tax situation to determine whether it makes the most sense to take additional distributions from tax-deferred accounts, triggering ordinary income, or sell taxable securities, triggering capital gains.
Taxes are complicated, and it's easy for clients to make mistakes without guidance. When compounding capital for retirement, a tax-planning error could be costly. Have a plan for clients to maximize the benefits of tax-advantaged accounts to secure a better financial future.
Share this end-investor version with your clients to help them better use tax-advantaged accounts.
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